Strategic Dependence and Inherent Risk Assessments

In auditing an account balance, an auditor must first assess the inherent risk that the balance is misrepresented. This paper identifies factors determining the accuracy of the auditor's inherent risk assessment in a hidden information audit setting, under the assumption that both players construct expec tations through a process of rational inference known as rationalization. The accuracy of the auditor's risk assessment is shown to be influenced by the risk of unintentional errors, the players' incentives, the precision of the auditor's data, and regulatory bounds on detection risk.